Learn what compound interest is and how it can be used to grow your savings.
Understanding compound interest
Compound interest is where you earn interest on both your initial deposit and on the interest that you’ve already earned, making the total invested at the end of each term greater than the last. This is a great way to help you reach your financial goals by complementing your everyday budgeting efforts.
How does compound interest work?
The concept of compounding, or compound investing, involves earning interest on your initial deposited amount together with the accumulated interest. Quite simply, it’s your money making more money over time. The longer your money has to compound, the bigger the potential impact on your overall savings.
How to calculate compound interest
If you want to calculate compound interest, you can use the commonly used compound interest formula. This will help you figure out how much your money will grow over a specific period of time. To estimate compound interest, you will need to know the initial balance, the interest rate, and the number of time periods.
Compound interest versus simple interest
The main difference between compound and simple interest lies in the calculation. Simple interest only involves the initial principal amount, while compound interest considers both the principal and the accumulated interest. This means that compound interest can potentially generate higher returns than simple interest, especially in the long run.
The example of compound interest versus simple interest is based on a $10,000 deposit with a 5% p.a. interest rate. This does not reflect current interest rates but is merely used as an example.
Balance at the end of year 1 | Balance at the end of year 2 | Balance at the end of year 3 | Balance at the end of year 4 | Balance at the end of year 5 | Total interest earned | |
|---|---|---|---|---|---|---|
Simple interest | $10,500 | $11,000 | $11,500 | $12,000 | $12,500 | $2,500 |
Compound interest* | $10,511.62 | $11,049.41 | $11,614.72 | $12,208.95 | $12,833.59 | $2,833.59 |
Difference in interest | $11.26 | $49.41 | $114.72 | $208.95 | $333.59 | $333.59 |
*The compound interest rate in the example only considers the initial deposit and not any additional deposits made on top. If deposits are made throughout the year that increase the amount to be reinvested, the total interest earned would be larger than when compared to simple interest.
Interest comparison scenarios
Chris and his simple interest account
Chris opened a savings account and deposited $10,000 with an annual interest rate of 5% p.a. paid monthly. At the end of the first year, Chris earns $500.00 from the initial deposit. Each year, he will earn an additional $500.00, and at the end of five years, Chris would have accrued $2,500 in interest on his account, not accounting for any additional deposits.
Alex and her compound interest savings account
Alex saved $10,000 and decided to open a savings account with an annual interest rate of 5% p.a. paid monthly. At the end of the first month, Alex earns $41.67 in interest, bringing the total amount to $10,041.67 for reinvestment in the second month. At the end of the second month, Alex will earn $41.84 in interest, making the total amount for reinvestment $10,083.51. By the end of 12 months, Alex’s total balance will be $10,511.62. After five years, Alex would have accrued $2,833.59 in interest with no additional deposits made except the compounded interest that rolled over each month.
Factors that will impact your compound interest
Compounding periods or terms
This is the frequency at which your interest is calculated and added to your account. Compounding periods or compounding terms can range from daily, monthly, quarterly, semi-annually, or annually. The more frequent the compounding, the more interest you could potentially earn over a specified time. For instance, if your interest compounds monthly, your investment will earn interest twelve times a year, which typically leads to higher overall returns than annual compounding.
Compounding interest rates
The interest rate will determine the growth rate of your money. Higher interest rates mean you’ll earn more interest overall, so your savings will grow faster. It’s a good idea to compare the types of accounts, such as savings accounts and term deposits, and the interest rates in these accounts to find the best option for you.
How to make the most of compound interest
Interest earned on most savings accounts automatically compounds, and the higher the interest rate is, the better outcome for your savings. But what more can you do to maximise your compounded interest?
Don’t just rely on your compounding interest account to grow your wealth. Consider your saving goals and look for day-to-day saving opportunities that can impact your overall financial goals.
Online tools will help you stay on track to reach your personal savings goals.
Depositing your savings into your compound interest account will help you continue to earn interest, leading to even greater growth. This is even more beneficial for long-term savings goals like retirement or large purchases like a house.
Choose an account with a high interest rate to make your money work a little harder with less effort.
